As part of Valuentum's process, we perform a rigorous discounted cash flow methodology that dives into the true intrinsic worth of companies. However, we're also well aware that only fools (and we don't mean Motley Fools) believe that they can forecast a company's future with absolute precision, and by extension, a company's intrinsic value with absolute precision. Remember, value is always based on the future. And while the future is unpredictable, to a degree, we cannot ignore it just because it is so. If we do, we ignore the value drivers behind a company and equity analysis almost in its entirety. In Sprint's (NYSE:S) case, we think the firm is fairly valued at $8, slightly lower than where it is trading today. Still, we acknowledge that a range of probable fair value outcomes is more appropriate for the company's analysis, especially given consolidation in the telecom industry. Saying a company is worth precisely this or precisely that is only going to result in being precisely wrong. Let's derive a probable range of fair value outcomes for Sprint in this article.
But first, a little background to help with the understanding of the article. We think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). Check out this video here about the logic behind the Valuentum process, and then please come back to the article.
If a company is undervalued, both on a DCF and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Sprint posts a Valuentum Buying Index score of 3 on our scale, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bearish technicals. Though relative valuation comparisons are always imperfect, we compare Sprint to peers AT&T (NYSE:T), CenturyLink (NYSE:CTL), and Verizon (NYSE:VZ). Still, the core of our process at Valuentum is grounded on discounted cash flow analysis and a margin of safety that results in the probable range of valuation outcomes that we mentioned above.
Our Report on Sprint
• Sprint's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. We think there are better quality firms out there.
• Sprint offers a comprehensive range of wireless and wireline communications services to over 50 million customers. The firm is widely recognized for developing innovative technologies, including the first wireless 4G service from a national carrier in the US.
• Sprint's cash flow generation is about what we'd expect from an average company in our coverage universe. However, the firm's financial leverage is on the high side. If cash flows begin to falter, we'd grow more cautious on the firm's overall financial health.
• Although we think there may be a better time to dabble in the firm's shares, based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.
• On a standalone basis, we value Sprint at $8 per share (our point estimate), while we could see a suitor bid as high as $12 per share (the high end of our fair value range) for its assets.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Sprint's 3-year historical return on invested capital (without goodwill) is 4.4%, which is below the estimate of its cost of capital of 11.8%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Sprint's free cash flow margin has averaged about 3% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Sprint, cash flow from operations decreased about 50% from levels registered two years ago, while capital expenditures expanded about 86% over the same time period.
Our discounted cash flow model indicates that Sprint's shares are worth between $4.00-$12.00 each. The margin of safety around our fair value estimate is driven by the firm's VERY HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The way to interpret this analysis is that during very, very tough times, a reasonable valuation for Sprint's shares could be in the $4 price range, but for an optimistic acquirer looking for synergies in a transaction, a $12 price tag could be fetched. We think having a fair value range is quite valuable in looking at companies. Valuentum provides a fair value range for all companies in its coverage universe.
Valuentum's discounted cash flow model reflects a compound annual revenue growth rate of 2% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 3.1%. Our model reflects a 5-year projected average operating margin of 6.6%, which is above Sprint's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.1% for the next 15 years, and 3% in perpetuity. For Sprint, we use a 11.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $8 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Sprint. We think the firm is attractive below $4 per share (the green line), but quite expensive above $12 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Sprint's fair value at this point in time to be about $8 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Sprint's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $11 per share in Year 3 represents our existing fair value per share of $8 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.